Best Practice Tips: Law Firm Goodwill and Valuation

Asked and Answered

By John W. Olmstead, MBA, Ph.D, CMC

Q. I am the owner of a six-attorney litigation firm in the San Francisco Bay area. I am 60 years old and starting to consider gradually transferring my interest to associates in the firm. I have heard other attorneys mention that I should get some goodwill out of my practice. I would appreciate your thoughts.

A. Many law firm owners prefer to leave a legacy and keep the firm "within the family." They transition the firm to non-equity partners or associates in the firm at a discounted value, and buy-in as an incentive to stay on with the firm.

Some law firms – typically second-generation or later firms – allow non-equity partners or associates to become equity owners with no buy-in whatsoever. The thought is that the real assets of the firm are its talent – its people – and the firm’s priority is to retain and keep the best talent that it can. These firms also do not have hefty buy-outs for partners or shareholders leaving the firm other than possibly the initial founders of the firm. Over the years, such firms fund retirement through 401ks, profit sharing plans, and other mechanisms. When partners or shareholders leave the firm, they get their cash-based capital account, or share of retained earnings, and their share of current year earnings.

A “founders benefit” is sometimes put in place for firm founders in which they may be paid a share of the accrual-based capital or retained earnings – WIP and A/R. They may also be paid a goodwill value as well, either in the form of a multiple of earnings or a specific sum based upon a multiple of gross revenue.

The problem in many firms is that associates are still paying off student loan debts and they don’t have cash available to purchase the owner’s interests. As a result, if you don’t start early, the money often has to come from future cash flows that are available after the owner leaves the firm.

You need to start early, get people committed, and start selling affordable minority shares years before you retire so you can get at least half of your ownership interest paid for before you leave the firm, and the other half paid during a five-year time period.

If you wait too long, your associates may feel they can just wait you out and inherit your clients without having to pay you anything.

John W. Olmstead, MBA, Ph.D, CMC, (www.olmsteadassoc.com) is a past chair and member of the ISBA Standing Committee on Law Office Management and Economics and author of The Lawyers Guide to Succession Planning published by the ABA. For more information on law office management please direct questions to the ISBA listserver, which John and other committee members review, or view archived copies of The Bottom Line Newsletters. Contact John at jolmstead@olmsteadassoc.com.